Why CPIH will be a poorer measure of headline UK inflation

On the Tuesday 21st March, the UK will be switching the headline inflation measure from CPI to CPIH. This is the first change in the main inflation measure for 14 years. This article examines what CPIH is, how it differs from CPI, why we are changing and what the implications might be.

CPIH is similar to the Consumer Prices Index (CPI) but attempts to add a measure of owner occupiers’ housing costs. The “H” effectively stands for “Housing”.

You might have expected that all our inflation indices include housing costs, as they are a significant part of most people’s lives. Indeed they are included in the UK’s original inflation statistic called RPI (Retail Prices Index). RPI fully weights in house prices, mortgage costs, council tax, water charges, repairs and maintenance, DIY costs, home insurance and ground rents.

However all housing-related costs are specifically excluded from CPI. The reason goes back to the EU. They invented a measure called the Harmonised Index of Consumer Prices (HICP) in the early 1990s. It was developed with the sole purpose of allowing comparisons to be made to determine if countries met the requirements of the Maastricht Treaty to join the Euro. At that time, European statisticians could not agree how to measure house prices, so they just compromised by leaving the whole area out of the measure. They argued it not matter, as HICP was never intended as a cost-of-living index, but was just a standardised benchmark for international comparisons.

The problem came when some countries, including the UK, started adopting HICP as their main inflation measure. The Bank of England did so in 2003 and renamed it CPI. The government may have been happy to use CPI because it usually produced lower inflation numbers. In the UK, CPI is on average approximately 1% lower than our original RPI measure. Lower inflation would have indicated good control over the economy and therefore reflected well on the government. Furthermore, as inflation is a key variable used to calculate GDP, lower inflation rates thus resulted in apparently higher economic activity, which again appearing to enhance any government’s prowess.

Nearly a decade after the introduction of CPI as the UK’s main measure and there was a general agreement that something needed to be done about the missing housing elements. Both ONS in the UK and Eurostat started to examine the options.

In late 2012 while the EU was reviewing the best solution, ONS unilaterally decided to act. It created a version of a measure called “Owner Occupiers’ Housing” costs, or OOH, and then added this to CPI to create a new index called CPIH. ONS decided not to follow the method established in RPI which includes all housing costs (see above list). In particular, they rejected the idea of including house prices or mortgage costs on theoretical grounds. They argued that house prices should be excluded as they were assets, and that mortgage costs were not really consumption costs. Both might be reasonable arguments from an academic point of view, but the alternative method they selected has a number of problems.

OOH calculates housing inflation using something called “Rental Equivalence” or RE for short. To calculate this, ONS have tried to estimate the average rental price of a UK home. They argued this might be a better way to calculate housing inflation; allowed relatively easy data collection; and that it is a reasonable proxy for the sum of all housing costs experienced by home owners. However there are reasonable grounds to doubt most of these assumptions – see discussion later.

As a further twist in the saga, ONS amended their definition of CPIH on the eve of it becoming the headline rate. On 13th March 2017, they decided to include Council Tax as well as OOH into CPI. Although useful to add in a genuine housing cost, the logic for not adding in all other housing expenditure such as ground rent, stamp duty, maintenance, etc was not explained. CPIH has therefore become an index based on “Rental Equivalence” but with one elements of what is called the “Payments Approach”.

The EU is now adopting a completely different method for calculating housing costs. This method is about to be proposed as a standard for all member states to collate. The EU thought it important that real house prices were included in some way and that all costs related to buying and maintaining a home should be included in their housing index. They have therefore adopted a method called “Net Acquisitions”, or NA for short.

There are reasons to think that even the EU approach leaves a certain amount to be desired. It is called “Net” because its main focus is on changes in the house prices of additional new homes. It ignores the price of the bulk of the housing sales i.e. of existing dwellings – hence the net bit. Ideally, they would have preferred to monitor the building costs of a house, having removed the land or asset price, but pragmatically decided this was too difficult to do. Despite these weaknesses, NA as a measure is significantly closer to the public’s expectations of a housing inflation statistic, as it at least includes a number of housing costs.

It is not just the EU who have taken issue with ONS’s method. The UK Statistics Authority (UKSA), have challenged it on a number of grounds. They were so concerned about ONS’s introduction of CPIH that they removed its designation as a national statistic back in 2014 and on 10th March 2017 re-affirmed that they are still remain unhappy with the approach ONS has taken.

UKSA has three main issues with CPIH:

  1. The most significant is that the absolute values and trends derived from the ONS numbers appear not to reflect other published measures of housing costs. For example, if you compare OOH with the housing price index produced as part of RPI (see graph), you can see that two are very different. Not only does OOH usually underestimate true housing costs, the pattern of changes seen is different and additionally appears to suffer a significant lag.
    OOH vs RPI HousingRPI’s measure of rental costs has risen almost half as much again as OOH since 2005. Indeed when you look at all the individual elements of housing costs, all but mortgage interest costs have risen substantially more than ONS’s OOH measure. In addition, the OOH measure seems relatively impervious to the gyrations of real housing related costs.OOHPart of the reasons for rents being a poor measure of all housing costs become obvious with a bit more thought. Rents charged are impacted by many other factors than just input costs e.g. by supply and demand. Most rents exclude housing costs such as water and council tax and so can never represent the impact of changes in these factors. Many rental agreements get set once a year and as such are always going to be a lagging measure of the impact of price rises that have impacted in the intervening period. There are also other issues with the sample and weighting of those rental properties which ONS is using.
  2. The UKSA wanted ONS to improve the quality standards in to the data collection. The rental figures they use come from the Valuation Office Agency (VOA) in England, Rent Offices Wales, Rent Services Scotland and from ONS’s own data collectors in Northern Ireland. This is a problem as ONS does not own most of this data and has only secured access to it on aggregate levels. This means it cannot work out weights of property types by region for example. Furthermore the total sampling frame of all rental properties in the UK is unknown and agencies such as the VOA do not have a random sample of all of them. The data cannot therefore be totally representative of all UK rents.
    To make it worse, should there be a change in government housing benefit policy, the relevant data may no longer be collected. Similarly, should Jeremy Corbyn be elected, he has promised to bring in rent controls. At that point, the variation in the data will merely reflect government policy and it will become irrelevant for measuring housing inflation.
  3. Finally the UKSA has is a broader issue, namely the degree of distrust users have in ONS’s concept of CPIH. To quote their latest report “the degree of user scepticism and disagreement is unusual for a national statistic”. They claim that the ONS has not engaged with users to determine the way they would like to see a housing index calculated. It is unclear if the UKSA mean Eurostat particularly or the large volume of hostile voices from consultations on the subject, or both.

In spite of the UKSA’s concerns, ONS chose to press ahead with adopting CPIH. They had stated, even as late as 28 October 2016, that they would only make CPIH the main headline measure once it had been designated a national statistic again by the UKSA. It was therefore a surprise two weeks later, before receiving an update from the UKSA, that they took the decision to do so. The launch date was announced on 10th November 2016 – the day after Trump’s election. It therefore received little media coverage at the time and few are even aware of the change and what it might mean.

The change to CPIH as the headline measure is therefore going happen on 21st March 2017. So what are the main implications of the change to CPIH. There are five main ones:

  1. It risks under-reporting the true level of inflation in the UK in the future. If CPIH had been the headline inflation rate for the last 10 years, it would have averaged about 0.15% lower. The under-reporting problem appears worse when inflation is high i.e above 2.5% – a period we just about to enter again.
    Note though that during the recent period of very low inflation rates, CPIH has sometimes been slightly higher, as it was in January 2017 (1.9% vs 1.8%).
  2. It risks reducing standards of living in the UK. Benefits, tax allowances and many pensions are all linked to the headline inflation rate, as are many wage rises. Should inflation be lowered by adopting CPIH, this will gradually erode the standards of living of many people over time – particularly of the poor and elderly.
  3. It could affect monetary policy if/when the Bank of England’s target is changed to CPIH. Inflation may be made to appear lower than it really is, delaying action on increasing interest rates. Also were the BoE to assume OOH reflects UK housing cost inflation, they could under-estimate housing’s impact on the economy.
  4. It risks invalidating international inflation comparisons. Despite Brexit, it makes little sense for the UK to go it alone with a different method of calculating its headline inflation rate versus the EU.
  5. Finally it risks severely undermining trust in UK statistics. If the public sees a housing index being reported that bears little resemblance to their experiences and other measures, this will further erode faith in government. It might also result in considerable anger, as it might appear to some to be an underhand way to reduce benefits and pensions.

Concluding thoughts

Back in 2003 when RPI was dropped in favour of CPI, the impact of changing housing costs was lost from the UK’s main inflation measure. There is thankfully now a consensus that housing needs to be included again. However where there is no agreement is in how it should be measured. As is often the case with statistics, there are conflicting views on how the numbers should be compiled because of the difference in the way different stakeholders perceive them and want to use them.

But ONS must remember that the most important stakeholder is the public. They seek an accurate measure of how much the cost-of-living is increasing. They use these numbers to ensure wages, pensions and other contracts are correctly adjusted.
Given this audience, there are three tests that an important statistic such as inflation must pass:

  • It must be worked out using a simple method that is easy for the public to understand
  • It must have validity i.e. it measures what is claims to measure
  • It has to reliably and accurately portray the price rises actually experienced by the total population.

OOH arguably fails all of these tests and as a result CPIH is going to be a poor measure of headline inflation.